The Return on Equity or ROE is perhaps one of the most important financial ratios from the perspective of shareholders. That’s because it is a measure of how well a business generates profits for every pound of shareholder dollar used in the company.
It is also one of the easiest ratios to calculate. Simply divide the annual net profit for the business (which you can find in the Profit & Loss account) by the total shareholder equity (which can be found in the company’s balance sheet).
Ideally you would want the company to generate as much profit as possible per dollar of shareholder equity. But beware!
A high ROE may be achieved by various means, one of which is for the company to borrow money. A business may decide to take on debt (otherwise known as increasing its financial leverage) to provide it with the extra cash needed to grow and run the business.
This could boost the ROE. But at some point the risk of taking on too much debt may outweigh the benefits. The upshot is that it could put shareholder capital at risk should the company default on its debts.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.